If you have regular
occasion to fill your car's tank with gas, you know that the price of gasoline
has recently been both high and volatile--a consequence, for the most part, of
similar movements in the price of crude oil.1
The weekly average price for a barrel of West Texas intermediate, a standard grade
of crude oil, hovered around $30 during the second half of 2003 but began to
rise around the turn of the year. The price per barrel reached $37 in March
and nearly $41 in May. Oil prices have continued to rise erratically since the
spring, even as other commodity prices have generally stabilized and overall
inflation has been low. As of last week, the price of a barrel of West Texas intermediate
stood at about $55.2

Some perspective
is in order. Oil prices are at record levels when measured in nominal terms, but
when adjusted for inflation the price of oil still remains well below its
historical peak, reached in 1981. Measured in today's dollars, crude oil
prices in 1981 were about $80 per barrel, and the price of gasoline at the pump
was nearly $3 per gallon. Moreover, energy costs at that time were a larger
share both of consumers' budgets and of the cost of producing goods and
services than they are today. Clearly, the surges in oil prices of the 1970s
and early 1980s had much more pronounced economic effects than the more recent
increases have had or are likely to have, barring a substantial further rise.

All that being
said, prices of oil and oil products in the United States today are quite high
relative to recent experience. During most of the 1990s, oil prices were roughly
$20 per barrel, and for a short period in 1998 (remembered without fondness by
oil explorers and producers) the price of a barrel of crude fell to just above $10.
As I mentioned, only a year ago the price of oil was about $30 per barrel. The
recent rise in oil prices has thus been large enough to constitute a
significant shock to the economic system.

The runup in oil
prices raises a number of important questions for economists and policymakers.
Why have oil prices risen by so much and why do they continue to fluctuate so
erratically? What is the outlook for oil supplies and oil prices in the medium
term and in the long term? What implications does the behavior of oil prices
have for the ongoing economic expansion? And how should monetary policy
respond to these developments? I will touch briefly on each of these questions
today. Before doing so, I should note that the opinions I express today are my
own and are not to be attributed to my colleagues in the Federal Reserve
System.3

Recent and Prospective Developments
in Oil MarketsTo assess recent
developments in the oil market, it would be useful to know whether the high
price of oil we observe today is a temporary spike or is instead the beginning
of an era of higher prices. Although no one can know for sure how oil prices
will evolve, financial markets are one useful place to learn about informed
opinion. Contracts for future deliveries of oil, as for many other
commodities, are traded continuously on an active market by people who have
every incentive to monitor the energy situation quite closely.4
Derivative financial instruments, such as options to buy or sell oil at some
future date, are also actively traded. The prices observed in these markets
can be used to obtain useful information about what traders expect for the
future course of oil prices, as well as the degree of uncertainty they feel in
predicting the future.

One inference we
can draw from recent developments in the oil market, in particular from the
pricing of derivative instruments, is that traders in that market are unusually
uncertain about how the price of oil will evolve over the next year or so. For
example, as of last week, traders assigned about a two-thirds probability that
the price of crude oil as of next June would be between $38 and $60 per
barrel. Or, to say the same thing another way, traders perceived a one-third
chance that the price of oil would fall outside the wide $38-$60 range. That
well-informed traders would be so uncertain about what the price of oil will be
only eight months in the future is striking, to say the least.

Uncertainty can in
itself be a negative factor for the economy; for example, I would not rule out
the possibility that uncertainty about future energy costs has made companies a
bit more cautious about making new capital investments. However, probably more
economically significant than near-term uncertainty about oil prices is the
fact that traders appear to expect tight conditions in the oil market to
continue for some years, with at best only a modest decline in prices. This
belief on the part of traders can be seen in the prices of oil futures
contracts. Throughout most of the 1990s, market prices of oil for delivery at
dates up to six years in the future fluctuated around $20 per barrel,
suggesting that traders expected oil prices to remain at about that level well
into the future. Today, futures markets place the expected price of a barrel of
oil in the long run closer to $39, a near doubling.5
Thus, although traders expect the price of oil to decline somewhat from recent
highs, they also believe that a significant part of the recent increase in
prices will be long lived.

What accounts for the
behavior of the current and expected future price of oil? The writer George
Bernard Shaw once said that, to obtain an economist, it was only necessary to
teach a parrot to repeat endlessly the phrase "supply and demand."
Well, as an economist, I have to agree with the parrot. For the most part, high
oil prices reflect high and growing demand for oil and limited (and uncertain)
supplies.

On the demand side, the
International Energy Agency (IEA), perhaps the most reliable source of data on world
oil production and consumption, has continued to revise upward its projections
of global oil usage. To illustrate, world oil consumption for the second
quarter of this year, the latest quarter for which we have complete data, is
now estimated to have been about 3.7 million barrels per day higher than the
IEA projected in July 2003.6
(For reference, total global oil consumption this year has averaged about 81
million barrels per day). A significant part of this unexpected increase in
oil consumption, about 2.2 million barrels per day, reflected quickly growing
oil demands in East Asia, notably China. However, an ongoing economic expansion
across both the industrialized and the emerging-market economies has also
contributed to the world's growing appetite for oil.

On the supply side, the
production of oil has been constrained by the available capacity and by
geopolitical developments. With oil consumption and prices rising briskly, Saudi
Arabia and other members of the Organization of Petroleum Exporting Countries
(OPEC) have promised to pump more oil. However, the relatively limited
increases in production delivered so far by OPEC members, together with
non-OPEC production that has fallen a bit below projections, have raised
concerns that the spare production capacity available in the near term may be
severely limited, perhaps below 1 million barrels per day.

Interacting with the
limits on capacity, and contributing to the exceptional volatility in oil
prices of recent months, are uncertainties about the reliability and security of
oil supplies. Of course, the oil-rich Middle East remains especially
volatile. But political risks to the oil supply have emerged in nations
outside the Middle East as well, including Russia, Venezuela, and Nigeria. Weather
also has taken a toll, as recent hurricanes affected the production and
distribution of oil on the U.S. Gulf Coast.

Because neither
the demand for nor the supply of oil responds very much to price changes in the
short run, the recent unexpected rise in oil consumption together with disruptions
to supply can plausibly account for much of the increase in prices. However,
the sharp increases and extreme volatility of oil prices have led observers to
suggest that some part of the rise in prices reflects a speculative component
arising from the activities of traders in the oil markets.

How might speculation
raise the price of oil? Simplifying greatly, speculative traders who expect
oil to be in increasingly short supply and oil prices to rise in the future can
back their hunches with their money by purchasing oil futures contracts on the
commodity exchange. Oil futures contracts represent claims to oil to be
delivered at a specified price and at a specified date and location in the
future. If the price of oil rises as the traders expect--more precisely, if
the future oil price rises above the price specified in the contract--they will
be able to re-sell their claims to oil at a profit.

If many
speculators share the view that oil shortages will worsen and prices will rise,
then their demand for oil futures will be high and, consequently, the price of
oil for future delivery will rise. Higher oil futures prices in turn affect
the incentives faced by oil producers. Seeing the high price of oil for future
delivery, oil producers will hold oil back from today's market, adding it to
inventory for anticipated future sale. This reduction in the amount of oil
available for current use will in turn cause today's price of oil to rise, an
increase that can be interpreted as the speculative premium in the oil price.

Many people take a
dim view of speculation in general, and in some instances this view is
justified.7
In many situations, however, informed speculation is good for society. In
the case of oil, speculative activity tends to ensure that a portion of the oil
that is currently produced is put aside to guard against the possibility of
disruptions or shortages in the future. True, speculation may raise the
current price of oil, but that increase is useful in stimulating current
production and reducing current demand, thereby freeing up more oil to be held
in reserve against emergencies. Speculative traders have no altruistic
motives, of course; their objective is only to buy low and sell high. But speculators'
profits depend on their ability to induce a shift in oil use from periods when
prices are relatively low (that is, when oil is relatively plentiful) to
periods when prices are relatively high (when oil is scarce). Social welfare
is likely increased by informed speculation in oil markets because speculative
activities make oil relatively more available at the times when it is most
needed.8

This discussion suggests
three indicators to help us detect the influence of speculative activity on
current oil prices. First, if speculative activity is an important source of
the rise in oil prices, we would expect today's oil price to react strongly to
news bearing on future conditions of oil supply and demand. Second, we should
see speculative traders holding claims to large amounts of oil for future
delivery, in the hope of enjoying a profit by re-selling the oil should prices
rise. Finally, corresponding to the speculative positions held by traders, we
would expect to see significant increases in the physical inventories of oil
being held for future use.

The first
indicator, rapid swings of oil prices in response to news about the prospective
supplies and usage of oil, does appear to be present and to suggest a
speculative element in pricing. It is thus somewhat puzzling that the other
two indicators of speculative activity do not appear to be present: Our best-available
measure of speculative traders' holdings of contracts for future delivery of
crude oil and petroleum products has decreased from earlier in the year and is
not unusually high by historical standards.9
And official data imply that physical inventories of crude oil and petroleum
products, at least within the industrial countries for which we have good data,
have not risen to any significant degree and at times have even been below
seasonal norms.10
Perhaps the official data overlook important accumulations of crude oil
stocks--in China and other emerging-market economies, for example--but that
remains (if you will excuse the expression) speculation. My tentative
conclusion is that speculative activity may help to account for part of the recent
volatility in oil prices. However, the available evidence does not provide
clear support for the view that speculative activity has made oil prices during
the past year much higher on average than they otherwise would have been.11

A rather different
explanation of the recent increase in oil prices holds that the rise is in
large part a symptom of inflationary monetary policies. An extensive
literature exists on this topic. The general idea is that, if most prices
adjust slowly, the effects of an excessively easy monetary policy will show up
first as a sharp increase in those prices that are able to adjust most quickly,
such as the prices of commodities (including oil). If this idea were valid,
then commodity price movements could be used as a guide for setting monetary
policy.

However, the
consensus that emerges from this literature is that the relationship between
commodity price movements and monetary policy is tenuous and unreliable at best.
Moreover, applied to the recent experience, economic models that support the
use of oil prices as a leading indicator of monetary policy make a number of
other predictions that are strongly contradicted by the facts. These
predictions include (1) that all commodity prices should move proportionally in
response to changes in monetary policy (in fact, oil prices have risen sharply
since the spring as other commodity prices have generally stabilized); (2) that
the dollar should have rapidly depreciated as the oil price rose (in fact, the
dollar has been broadly stable during 2004); (3) that inflation expectations
should have increased substantially (but long-term nominal interest rates, the
level of inflation compensation implicit in inflation-indexed bond yields, and
survey measures of inflation expectations concur in showing no such rise); and
(4) that general inflation, though lagging commodity-price inflation, should
also rise over time (but inflation excluding energy prices remains quite low). Models
of commodity-price "overshooting" also imply that the current surge
in oil prices will be almost entirely temporary, a prediction strongly at
variance with market expectations as revealed in the futures markets. I
conclude that an increasingly tight supply-demand balance, rather than
speculation or easy monetary policies, probably accounts for most of the recent
run-up in oil prices.

I have focused on
near-term developments in the oil markets. What about the longer term? In
that regard, we can safely assume that world economic growth, together with the
rapid pace of industrialization in China, India, and other emerging-market
economies, will generate increasing demands for oil and other forms of
energy. If we are lucky, growth in the demand for energy will be moderated by
continued improvements in energy efficiency that will be stimulated by higher
prices and concerns about the security of oil supplies. Such improvements are
certainly possible, even without new technological breakthroughs. For example,
Japan is an advanced industrial nation that uses only about one-third as much
energy to produce each dollar of real output as the United States does.12
Industrializing nations such as China appear to be quite inefficient in their
energy use; for example, the underdeveloped electricity grid in China has
induced heavy use of inefficient diesel-powered generators. As these countries
modernize, their energy efficiency will presumably improve. Still, if the
global economic expansion continues, substantial growth in the use of oil and
other energy sources appears to be inevitable.

The supply side of
the oil market is even more difficult to predict. In a physical sense, the
world is not in imminent danger of running out of oil. At the end of 2003, the
world's proved reserves of oil--that is, oil in the ground that is viewed as
recoverable using existing technologies and under current economic
conditions--reached more than 1.15 trillion barrels, 12 percent more than the
world's proved reserves a decade earlier and equal to about forty years of
global consumption at current rates (BP Statistical Review of World Energy,
2004, p. 4). Of course, global oil consumption will not remain at current
rates; it will grow. But, on the other hand, today's proved reserve figures
ignore not only the potential for new discoveries but also the likelihood that
improved technology and higher oil prices will increase the amount of oil that
can be economically recovered.

The oil is there, but
whether substantial new production sources can be made available over the next
five years or so is in some doubt. Some important fields are in locations that
are technically difficult and time-consuming to develop, such as deep-water
fields off West Africa, in the Gulf of Mexico, or off the east coast of South
America. In many cases, the development of new fields also faces the
challenge of recovering the oil without damaging delicate ecosystems, if indeed
the political process allows exploitation of ecologically sensitive fields at all.
I have already noted the uncertainties generated by geopolitical instability;
perhaps it is sufficient here to note that, despite the opening of fields in a
number of new regions in the past decade, about 63 percent of known oil
reserves today are in the Middle East. Oil producers are also aware from
painful experience that oil prices can fall as quickly as they rise; hence,
exploration projects launched when prices are high may come to fruition when
prices are much lower. These risks help to explain why major oil companies
have not rushed to increase exploration activities during this recent period of
high prices.

Thus, the supply-demand
fundamentals seem consistent with the view now taken by oil-market participants
that the days of persistently cheap oil are over. The good news is that, in
the longer run, we have options. I have already noted the scope for
improvements in energy efficiency and increased conservation. Considerable
potential exists as well for substituting other energy sources for oil,
including natural gas, coal, nuclear energy, and renewable sources such as wind
and hydroelectric power. For example, the world has vast supplies of natural
gas that, pending additional infrastructure development, might be transported
in liquefied form to the United States, Europe, Asia, and elsewhere at BTU-equivalent
prices below those expected for crude oil. Given enough time, market
mechanisms (most obviously, higher prices) are likely to increase energy
supplies, including alternative energy sources, while simultaneously
encouraging conservation and substitution away from oil to other types of
energy. These adjustments will not occur rapidly, however. Hence the next few
years may be stressful ones for energy consumers, as stretched and uncertain
supplies of oil and other conventional energy sources face the growing demands
of a rapidly expanding world economy.

Economic and Policy Implications
of Increased Oil Prices What are the economic
implications of the recent increase in oil prices? In the long run, higher oil
prices are likely to reduce somewhat the productive capacity of the U.S. economy.
That outcome would occur, for example, if high energy costs make businesses
less willing to invest in new capital or causes some existing capital to become
economically obsolescent. Lower productivity in turn implies that wages and profits
will be lower than they otherwise would have been. Also, the higher cost of
imported oil is likely to adversely affect our terms of trade; that is, Americans
will have to sell more goods and services abroad to pay for a given quantity of
oil and other imports. The increase in the prices of our imports relative to
the prices of our exports will impose a further burden on U.S. households and
firms.

Under the
assumption that oil prices do not spike sharply higher from their already high
levels, these long-run effects, though negative, should be manageable. As I
have already discussed, conservation and the development of alternative energy
sources will, over the long term, take some of the sting out of higher oil
prices. Moreover, productivity gains from diverse sources, including
technological improvements and a more highly educated workforce, are likely to
exceed by a significant margin the productivity losses created by high oil
prices.

In the short run,
sharply higher oil prices create a rather different and, in some ways, a more
difficult set of economic challenges. Indeed, a significant increase in oil
prices can simultaneously slow economic growth while stoking inflation, posing hard
choices for monetary policy makers.

An increase in oil
prices slows economic growth in the short run primarily through its effects on
spending, or aggregate demand. Because the United States imports most of its
oil, an increase in oil prices is, as many economists have noted, broadly analogous
to the imposition of a tax on U.S. residents, with the revenue from the tax going
to oil producers abroad. Since the beginning of the year, the cost of oil
imported into the United States has increased by about $75 billion (at an
annual rate), or about 3/4 percent of the gross domestic product (GDP). Add to
this the effects of the rise in natural gas prices, and the total increase in
imported energy costs over a full year--the increase in the "tax"
being paid to foreign energy producers--comes to almost $85 billion.

The impact of this
decline in net income on the U.S. GDP depends in large part on how the increase
in the energy "tax" affects the spending of households and firms.
For a number of reasons, an increase of $85 billion in payments to foreign
energy producers is likely to reduce domestic spending by something less than
that amount. For example, in the short run, people may be reluctant to cut
non-energy spending below accustomed levels, leading them to reduce saving
rather than spending. Because high energy costs lower firms' profits, they normally
reduce the willingness of firms to purchase new capital goods; however, if the
increase in energy prices looks to be permanent, firms might decide that it
makes sense for them to invest in more energy-efficient buildings and machines,
moderating the decline in their capital spending. If higher energy prices reflect
in part more rapid economic growth abroad--which seems to be the case in the recent
episode--or if foreign energy producers spend part of their increased income on
U.S. goods and services, then the demand for U.S. exports may be stronger
than it would have been otherwise. With these and many other qualifications
taken into account, a reasonable estimate is that the increased cost of
imported energy has reduced the growth in U.S. aggregate spending and real
output this year by something between half and three-quarters of a percentage
point.

At the same time that
higher oil prices slow economic growth, they also create inflationary pressures.
Higher prices for crude are passed through, with only a very short lag, to
increased prices for oil products used by consumers, such as gasoline and
heating oil. When oil prices rise, people may try to substitute other forms of
energy, such as natural gas, leading to price increases in those alternatives
as well. The rise in energy costs faced by households represents, of course,
an increase in the cost of living, or inflation. This direct effect of higher
energy prices on the cost of living is sometimes called the first-round
effect on inflation. In addition, higher energy costs may have indirect
effects on the inflation rate--if, for example, firms pass on their increased
costs of production in the form of higher consumer prices for non-energy goods
or services, or if workers respond to the increase in the cost of living by
demanding higher wages. These indirect effects of higher energy prices on the
overall rate of inflation are called second-round effects. The overall
inflation rate reflects both first-round and second-round effects, of course.
Economists and policymakers also pay attention to the so-called core inflation
rate, which excludes the direct effects of increases in the prices of energy (as
well as of food). By stripping out the first-round inflation effects, core
inflation provides a useful indicator of the second-round effects of increases
in the price of energy.13

In the past,
notably during the 1970s and early 1980s, both the first-round and second-round
effects of oil-price increases on inflation tended to be large, as firms freely
passed rising energy costs on to consumers, and workers reacted to the surging
cost of living by ratcheting up their wage demands. This situation made
monetary policy making extremely difficult, because oil-price increases
threatened to raise the overall inflation rate significantly. The Federal
Reserve attempted to contain the inflationary effects of the oil-price shocks by
engineering sharp increases in interest rates, actions which had the
unfortunate side effect of sharply slowing growth and raising unemployment, as
in the recessions that began in 1973 and 1981.

Since about 1980,
the Federal Reserve and most other central banks have worked hard to bring
inflation down, and in recent years, inflation in the United States and other
industrial countries has been both low and stable. An important benefit of
these efforts is that the second-round inflation effect of a given increase in
energy prices has been much reduced (Hooker, 1999). Because households and
business owners are now confident that the Fed will keep inflation low, firms
have both less incentive and less ability to pass on increased energy costs in
the form of higher prices, and likewise workers have less need and less
capacity to demand compensating increases in wages. Thus, increases in energy
prices, though they temporarily raise overall inflation, tend to have modest
and transient effects on core inflation; that is, currently, the second-round
effects appear to be relatively small.

Although the
difficulties posed by increases in oil prices are less than in the past, the economic
consequences are nevertheless unpleasant, as higher oil prices still tend to induce
both slower growth and higher inflation. How then should monetary policy
react? Unfortunately, monetary policy cannot offset the recessionary and
inflationary effects of increased oil prices at the same time. If the central
bank lowers interest rates in an effort to stimulate growth, it risks adding to
inflationary pressure; but if it raises rates enough to choke off the
inflationary effect of the increase in oil prices, it may exacerbate the slowdown
in economic growth. In conformance with the Fed's dual mandate to promote both
high employment and price stability, Federal Reserve policy makers would
ideally respond in some measure to both the recessionary and inflationary
effects of increased oil prices. Because these two factors tend to pull policy
in opposite directions, however, whether monetary policy eases or tightens
following an increase in energy prices ultimately depends on how policymakers
balance the risks they perceive to their employment and price-stability
objectives.

An important
qualification must be added, however. The relatively small effects of higher
oil prices on the underlying inflation rate that we have seen in recent years
are a consequence of the public's confidence that the Fed will maintain
inflation at a low level in the medium term. As I have discussed, the public's
expectation that inflation will remain low minimizes the second-round effects
of oil price increases, which (in a virtuous circle) helps to limit the
ultimate effect on inflation. Moreover, well-anchored inflation expectations have
been shown to enhance the stability of output and employment. Maintaining the
public's confidence in its policies should thus be among the central bank's
highest priorities.14
For this reason, I would argue that the Fed's response to the inflationary
effects of an increase in oil prices should depend to some extent on the
economy's starting point. If inflation has recently been on the low side of
the desirable range, and the available evidence suggests that inflation
expectations are likewise low and firmly anchored, then less urgency is
required in responding to the inflation threat posed by higher oil prices. In
this case, monetary policy need not tighten and could conceivably ease in the
wake of an oil-price shock. However, if inflation has been near the high end
of the acceptable range, and policymakers perceive a significant risk that
inflation and inflation expectations may rise further, then stronger action, in
the form of a tighter monetary policy, may well prove necessary. In directing
its policy toward stabilizing the public's inflation expectations, the Fed
would be making an important investment in future economic stability.

I will close by briefly
linking this discussion to recent Federal Reserve policy. As a professor and textbook
author, I was accustomed to discussing the effects of a particular phenomenon,
such as rising oil prices, with all other factors held equal. However, as
policymakers know, everything else is never held equal. The increases in oil
prices this year did not take place in isolation. Along with the rise in oil prices,
increases in the prices of other important commodities, such as steel and
lumber, as well as higher import prices resulting from the earlier decline in
the dollar, provided supply-side pressure on inflation in early 2004.
Meanwhile, an economic expansion that took hold in the middle of 2003 resulted
in strong output growth but, as of early this year, limited progress in
creating new jobs. As a final complication, the beginning of the year also saw
the Fed's policy interest rate, the federal funds rate, at the historically low
level of 1 percent, the result of the efforts of the Federal Open Market
Committee (FOMC) to spark faster growth and minimize deflation risks in 2003.
In January, with inflation low and the job market still weak, the FOMC
indicated that it would be "patient" in removing the policy
accommodation implied by the low value of the federal funds rate.

The increase in
inflation that occurred last spring posed a choice for the FOMC. Should the Committee
remain "patient" in the face of this development, or should it move
more aggressively to meet an emerging inflation threat? The answer, I would
argue, properly depended on both the source of the inflation and the state of
inflation expectations. In particular, if the pickup in inflation had largely
resulted from an overheating economy and a consequent increase in pricing power
and wage demands, a more-aggressive policy would have been appropriate. The
FOMC's analysis of the situation, however, was well described by the statement
issued after its June meeting. In that statement, the Committee suggested that
the increase in inflation was due at least in part to "transitory factors"--a
heading under which I include the increases in oil prices, commodity prices,
and import prices--and indicated as well that "underlying inflation"
would likely remain low, which I interpret as saying that, with medium-term
inflation expectations well contained, second-round effects appeared likely to
be small. The implication of this analysis was that the FOMC could remain "patient."
Thus far at least, the FOMC's diagnosis appears to have been correct, as both
headline and core inflation have receded from the levels of last spring.

Looking forward, I am
sure that the Committee will continue to watch the oil situation carefully.
However, future monetary-policy choices will not be closely linked to the
behavior of oil prices per se. Rather, they will depend on what the
incoming data, taken as a whole, say about prospects for inflation and the
strength of the expansion. Generally, I expect those data to suggest that the
removal of policy accommodation can proceed at a "measured" pace.
However, as always, the actual course of policy will depend on the evidence,
including, of course, what we learn about how oil prices are affecting the
economy.

As the FOMC evaluates its
policy options, retaining public confidence in the Federal Reserve's commitment
to price stability will continue to be essential. If the public were not fully
assured of that commitment, the FOMC would find achieving its objectives of
price stability and maximum sustainable employment to be difficult if not
impossible. For that reason, I fully endorse the sentiment in the last few
FOMC statements that "the Committee will respond to changes in economic
prospects as needed to fulfill its obligation to maintain price stability."

1.
Although gasoline prices generally rise and fall with the price of crude oil,
in the short run the linkage can be relatively loose. One reason that oil and
gasoline prices do not march in lockstep is that the margins that refiners and
distributors of gasoline can command may vary significantly over time,
depending on such factors as the availability of refinery capacity, seasonal
variations in the demand for gasoline, and regional imbalances in gasoline
supply. Return to text

2.
The price of West Texas intermediate (WTI) is often cited in the media, which
is why I have used it as an example here. For consistency, in the remainder of
the talk, when I refer to oil prices I mean the price of WTI. However, as a
particularly desirable grade of "light, sweet" oil, WTI commands a premium
price. The average price of crude oil imported into the United States is
currently about $40 per barrel, about $15 less than the price of WTI. Return to text

3.
I thank William Helkie and Charles Struckmeyer, of the Board's staff, for their
excellent assistance. Return to text

4.
Oil futures and other oil-related derivatives are traded on the New York
Mercantile Exchange (NYMEX) and the International Petroleum Exchange (IPE) as
well as over the counter. Return to text

5.
I should acknowledge that oil futures prices have a less-than-stellar record in
forecasting oil price developments, but they are probably the best guide that
we have. Chinn, LeBlanc, and Coibion (2001) find that futures quotes are
unbiased predictors of future spot prices, though not very accurate ones. Return to text

6.
Saudi Arabia and other OPEC members, like the IEA and most participants in
the oil markets, did not anticipate the surge in consumption we have seen this
year either. OPEC actually reduced its production targets in 2003 and again in
early 2004 out of concern that weak oil demand would cause price declines. Return to text

7.
For example, we know of historical examples of speculators "cornering" a
market, leading to wild price fluctuations unjustified by fundamentals. Return to text

8.
In addition to helping ensure that oil is used at the socially most valuable
time, speculation also reduces risks for producers and consumers of oil. For
example, an oil producer who sells oil for future delivery receives a
guaranteed price today and does not have to bear the risk that the price will drop
sharply before the oil delivery date. Return to text

9.
The measure used here is net long futures positions of noncommercial traders
(that is, traders who do not have a direct hedging need). These data,
available from the Commodity Futures Trading Commission, do not perfectly
measure speculative activity, as they do not cover all trading in oil futures,
nor do they necessarily cleanly distinguish speculators from other traders. Return to text

10.
Oil market data for the United States, including inventories data, are released
weekly by the Energy Information Administration, part of the U.S. Department of
Energy. Each month, the International Energy Agency releases analogous
information covering the thirty member countries of the Organisation for
Economic Co-operation and Development (OECD). Return to text

11.
Weiner (2002) surveys the academic literature and concludes that, over the long
term, speculative activity has not much affected the average price of oil. The
apparently strong effect on oil prices of recent hurricanes in the Gulf of
Mexico, which led to short-term reductions in production, is a bit of evidence
that high prices reflect a tight supply-demand balance rather than speculative
hoarding. If inventories or spare production capacity had been available, the
shortfalls created by hurricanes could have been replaced, and the price effect
would have been more muted.

A somewhat different question
is whether future prices for oil contain a significant risk premium. The
finding of Chinn, LeBlanc, and Coibion (2001) that futures prices are unbiased
predictors of future spot prices argues against a large risk premium.
Estimates by the Board's staff, based on the methods of Pindyck (2001),
indicate that the risk premium in oil futures was no more than $2 or so even
during the recent spikes in prices. Return to text

12.
Japan may set an unreasonably high standard: That country's small area
reduces the use of energy for transportation, and the low average size of homes
on these densely populated islands reduces heating and cooling costs. Japan
also produces a different mix of goods and services than the United States, a
mix that may be less energy-intensive. On the other hand, not even Japan has
made full use of the energy conservation potential of existing technologies,
such as hybrid autos for example. Return to text

13.
As discussed earlier, higher energy prices may also lower the economy's
productive capacity, by reducing investment and making a portion of the capital
stock un-economical to operate. This decline in potential output puts
additional upward pressure on the inflation rate. Return to text

14.
As my colleague Edward Gramlich put it in his recent remarks on oil price
shocks and monetary policy, "The worst possible outcome is for monetary
policy makers to let inflation come loose from its moorings" (Gramlich, 2004). Return to text